Following up on my post on the subject, I had the opportunity to speak with Colin O’Keefe of LXBN regarding the Facebook/Instagram deal.  In the brief interview, I explain how things have changed since Facebook’s IPO and what, if anything, that meant for the deal’s fairness review with the California Department of Corporations.

California Department of Corporations, One Sansome Street, San Francisco

We previously blogged about the potential liability for Facebook, Inc. directors if the company paid too much for the social media start-up company Instagram. Recall that in April, Facebook agreed to acquire Instagram for, at the time, approximately $1 billion with the consideration payable 30% in cash and 70% in Facebook common stock (now, due to the decrease in Facebook’s share price from the stipulated price of $30 per share, the deal is only worth about $650 million). A recent NY Times Deal Book article points out that if the deal fixed the total purchase price rather than the number of shares to be issued, Instagram would have gotten a much better deal due to the depressed Facebook share price. Given the declining share price of Facebook stock, is Facebook’s reduced consideration still fair to Instagram’s shareholders? This is exactly the question that will be determined by the California Department of Corporations which will be conducting a fairness review of the acquisition this Wednesday.

The purpose of this fairness hearing is to allow Facebook to take advantage of a lesser-known exemption from registration under the Securities Act of 1933 known as the “3(a)(10) exemption.” Because Facebook is issuing securities in connection with the Instagram acquisition, the 23 million shares to be issued are required to either be registered or they must be exempt from the registration requirements of the Securities Act. The 3(a)(10) exemption allows companies to issue securities in an exchange transaction without registration provided that either a court or designated state agency finds that the transaction is fair to the recipients of the new securities. This exemption was popular during the tech boom and has both advantages and disadvantages when compared with the most common exemption provided by Rule 506 of Regulation D promulgated under the Securities Act. 

Most smaller companies tend to offer and sell securities on an exempt basis because of the substantial costs of conducting a registered offering. There are a laundry list of exemptions but only a few are of much practical use. Most exempt offerings are structured to take advantage
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More interesting times have arrived for holders of Facebook stock. The stock, which has been brutally beaten down from its IPO price, faces new challenges as the “lockup” restrictions (which have been in place since the IPO) began to expire on August 16. This means that a significant number of Facebook shareholders are now able to sell their shares in the open market, and significant numbers of Facebook shares will be freed from these restrictions over the next few months. The sale of a substantial number of Facebook shares could obviously drive the stock price down even more. The big questions now:  Who will or won’t sell their stock as these restrictions lapse?

This situation is also a great lesson for entrepreneurs who are contemplating the possibility of taking their companies public. Most observers thought that Facebook’s IPO was a certain success, but so far it’s been a very tough road. One big concern here is that the problems that Facebook has faced with its transition to public company status will divert management’s attention from the company’s business tactics and strategy at a very critical time. 

Facebook went public at a price of $38 per share. Many observers felt that this price was too high, and the market apparently agreed. The stock has not been back to its IPO price since the first day of trading, and its closing price on August 17 was $19.05 per share (a 49.9% decline from the IPO price). The stock price went below $19.00, but has since rebounded to close at $19.44 today. In any case the company has lost almost half of its market value since the IPO. Even at this reduced price the stock is still trading at about 30 times projected next years’ earnings. It’s interesting to note that Google and Apple currently trade at 12 to 13 multiples, so Facebook’s stock is still very highly valued even after its decline.

Lockup restrictions on stock sales by insiders and other parties are normally demanded by underwriters as part of the IPO process. These restrictions help to reduce volatility in the market price of a newly public company’s stock, and they help to ensure that existing shareholders
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The “Risk Factors” section of any disclosure document is vital to the protection of the issuer. Generations of securities lawyers and accountants have worked into the night to develop lists of risks that would make any sane potential investor run away screaming. Most of us have seen innumerable examples of conventional risk factors like competition, legal and regulatory changes, impact of the loss of key personnel and others. Many of these risk factors are virtually identical regardless of the issuer’s industry space, and it’s doubtful that many readers of disclosure materials pay much attention to these risk factors.

The new breed of public technology companies, however, present some novel and interesting risks. The disclosure of these risks still strives to protect the issuer and give the potential purchaser the relevant information necessary to make an informed investment decision, but they focus on areas that are quite different from the disclosures used by more conventional companies. These technology company disclosure documents still contain many conventional risk factors, but it’s interesting to see the new areas that are considered material risks for these companies.

Here are several of the key items that been used as material risk factors in recent technology company disclosure documents filed by prominent technology companies:

Data Security.  This is a very hot issue for most technology companies these days, especially in the social media space. Facebook is a great example, as it has data from close to 900 million users. LinkedIn has similar dynamics and issues on a smaller scale. A data breach for any of these companies would have huge legal ramifications, as state, Federal and international regulatory authorities and private plaintiffs would quickly react. LinkedIn recently experienced these negative ramifications first hand as it was sued for $5 million in connection with its recent data breach.  The potential damage to a company’s brand and credibility could also be significant.  Click here for language from the Facebook prospectus and the LinkedIn prospectus as good examples. The SEC also offered some guidance on this topic in “CF Disclosure Guidance Topic No. 2 – Cybersecurity”.
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Facebook’s IPO seemed like a sure thing only a short time ago. This iconic leader in the technology space led by a charismatic CEO seemed destined to have a blockbuster IPO. The IPO encountered a number of substantial problems and challenges, however, and the stock’s post-IPO performance has been far less than stellar, with none of the big increase in the stock price that was widely anticipated. This IPO is now widely viewed as flawed and as a failure in many respects.

 After three full trading days, Facebook’s shares are trading about 16% below the IPO price. The stock closed slightly above its IPO price on its first day of trading, but this only happened because the underwriters bought enough shares to support the stock. A variety of problems contributed to this poor debut, including the sale of large blocks of stock by existing Facebook shareholders, General Motors’ last minute decision to curtail substantial advertising on Facebook, a negative assessment of Facebook’s second quarter revenue forecast by analysts for the lead underwriter (which was allegedly only shared with potential large institutional purchasers), strange technical glitches at NASDAQ and the underwriters’ decision to increase both the number of shares sold and the offering price. Facebook’s final IPO prospectus can be found here.

The stock’s performance suggests that the underwriters’ original valuation ($34 per share) was only slightly higher than the company’s valuation as perceived by investors. The decision to take the IPO price to $38 per share increased the valuation beyond this perceived fair value. The subsequent decline in the stock value has taken the stock price down to a level that the market perceives is reasonable.

While Facebook’s current and prospective problems are daunting, the company was able to raise a huge amount of money at a premium to its actual value, so the IPO transaction was beneficial to the company. This is understandable given the tremendous demand for the stock that existed prior to the IPO, even in light of the problems that existed. The post-IPO results so far, while disappointing when compared to other technology IPOs, are short term and will correct themselves if the company increases its value. I’m actually surprised that the IPO price was as low as it was given the extremely high profile of this offering, but the significant negative factors that surrounded the offering contributed to this. In any case the company’s final valuation was still a huge multiple of historical earnings.


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It is a basic tenant of corporate law that directors of a corporation are not liable for business decisions as long as the directors acted with a reasonable level of care in making these decisions. This is referred to as “the business judgment rule.” Because directors are not guarantors of corporate success, the business judgment rule specifies that a court will not review the business decisions of directors who performed their duties (1) in good faith; (2) with the care that an ordinarily prudent person in a like position would exercise under similar circumstances; and (3) in a manner the directors reasonably believe to be in the best interests of the corporation. As part of their duty of care, directors have a duty not to waste corporate assets by overpaying for property (e.g., 100% of the stock of a target company in an acquisition) or employment services. The business judgment rule is very difficult to overcome and courts will not disregard it absent, among other things, a showing of fraud or misappropriation of corporate funds.

One of the landmark cases in this area of law was Smith v. Van Gorkam, which was decided by the Delaware Supreme Court in 1985. In that case, the board of directors of TransUnion approved a merger with Marmon Group without consulting outside experts as to the fairness of the price to be paid to TransUnion shareholders, rather, the board relied on the recommendations company’s CEO and CFO, neither of whom made any substantive attempt to determine the actual value of TransUnion. Additionally, the board did not inquire as to the process used by the CEO and CFO in determining the merger consideration. As a result, the Delaware Supreme Court found that the directors of TransUnion were grossly negligent in carrying out their fiduciary duties to the company. Because of this, the board was found not to have satisfied their duty of care and were therefore not entitled to the presumptions and protections of the business judgment rule. Ultimately, the TransUnion board agreed to pay $23.5 million in damages resulting from their fiduciary duty breaches.

The facts of Facebook’s recently announced acquisition of Instagram (as reported by the Wall Street Journal) are strikingly similar to the Van Gorkam case. Allegedly, Facebook’s CEO Mark Zuckerberg and Instagram’s CEO Kevin Systrom worked out the details of the acquisition privately over the course of 3 days at Mr. Zuckerberg’s home. Once the details were finalized for the $1 billion acquisition, the deal was presented, without notice, to the Facebook board of directors who approved the deal, likely without outside expert advice as to the fairness of the transaction. According to several reports, the board vote was largely symbolic because Zuckerberg has control of 57% of the voting power of the company. Facebook directors were likely put in a precarious
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One of the most well-known and popular Internet companies, Groupon, Inc., has again encountered significant accounting problems. These problems appear to be potentially severe. This situation is very negative for Groupon, but it also has troubling ramifications for the entire technology industry and especially for technology companies that have recently gone public. There is

As reported in the Wall Street Journal, Facebook, Inc. filed a registration statement with the SEC late Wednesday to register to go public.  This continues the recent trend of established technology companies going public since the beginning of last year.  Whether the stock price ultimately supports its expected lofty valuation remains to be seen.

While the IPO has been long-expected, it is important to remember the reason why Facebook decided to go public: it was required.  Section 12(g) of the Securities Exchange Act of 1934 requires companies that have at least $10,000,000 in assets and at least 500 shareholders as of the end of its fiscal year to register with the SEC.  This shareholder limit has not been adjusted since its adoption in 1964, and causes companies that need to raise capital to face two equally unappealing choices: limit the number of investors to ensure the 500 limit is not breached or register with the SEC regardless of whether being a public company is in the company’s best interests once the limit is met.  While a recent proposed bill in the House has attempted to lessen the burden on private companies looking to raise capital by increasing the shareholder limit from 500 to 1000, to date no legislation has been enacted into law.  The SEC is also reviewing the shareholder limit.

Until Congress or the SEC acts, private companies should consider taking a few safeguards to avoid the requirement to register with the SEC.  First, adopt a shareholders’ agreement that restricts the transferability of the shares.  The transfer restriction will prevent shareholders from subsequently transferring their shares to multiple new shareholders which could cause the company to exceed the limit.  Second, issue stock options to employees rather than shares of stock.  Stock options are considered a separate class of equity security, and since 2007, the SEC has exempted companies from having to register under Section 12(g) because there were more than 500 option holders.  Third, private companies can adopt an insider trading policy that prohibits any employee from reselling their shares.  Facebook adopted such a policy, which effectively eliminated the secondary distribution of its shares.  Fourth, companies can implement high transfer fees to restrict the distribution of its shares similar to the fees
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